One of the biggest mistakes you can make about our tax system is trying to act as if it was simple. Take the instance of a landlord who acquires a property for letting, and does repair or renewal work on it before the first tenant moves in.
‘Capital’ or ‘revenue’ expenditure?
The simple approach would be to assume that pre-letting repairs etc., because they presumably increase the value of the property (the property cost you less because the repairs needed to be done), are effectively improvement expenditure, which is therefore ‘capital‘ and not claimable against rents.
The main authority for this, which some tax inspectors will trot out with monotonous regularity, is the Law Shipping case, which dates from 1923 (Law Shipping Co Ltd v CIR, CS 1923, 12 TC 621). The taxpayer bought a second-hand ship, and had to spend a lot of money on repairs – typically, the need for these only became apparent after the ship had been bought! The judge observed that ‘the sellers would have demanded and obtained a higher price than they actually did, but for the immediate necessity of repairs to which the ship was subject‘. Result: most of the expenditure was disallowed as being capital, and effectively part of the acquisition cost of the boat.
However, just as often as HMRC bring forward Law Shipping to support disallowance of repairs, well-advised taxpayers counter this by playing the ‘Odeon Cinemas‘ card.
This is a more recent case, dating from 1971 (Odeon Associated Theatres Ltd v Jones, CA 1971, 48 TC 257) – although the expenditure that was in dispute between the taxman and Odeon was expenditure incurred over a period of several years following the Second World War.
The expenditure in dispute here was repair and redecoration of a large number of cinemas, which had become dilapidated during the war because there were wartime restrictions on building work. Although the buildings were tatty, they were still able to be used, and this was an important factor in the decision. The court decided that the whole of the expenditure was allowable, unlike in the Law Shipping case, since in that case the ship could not have been used without the necessary repairs, whereas here the cinemas remained usable despite their state of disrepair.
One puzzling feature of the Odeon case, as it is reported, is that it appears to have been accepted that the state of disrepair of the buildings had not affected their purchase price, unlike the situation with the ship in the Law Shipping case. This seems hard to believe on basic principles, as any property’s value is going to be discounted if it needs a lot of repair work done on it, in the real world.
Thus, what Odeon really does is ‘muddy the waters ‘, so that we can’t just take the simple approach of disallowing expenditure, which improves the value of a newly acquired building.
Whilst both of these cases relate to trading businesses rather than property letting businesses, the same basic principles apply in working out property business profits as trading business profits.
HMRC’s view
HMRC’s own guidance doesn’t completely clear up this rather muddy bit of water either. Considering the position of repairs undertaken shortly after a property has been acquired, they concede, following Odeon, that ‘the mere fact that the taxpayer bought the asset not long before the repairs are made does not in itself make the repair a capital expense (and therefore disallowable)’. However, there are other factors which could make the expenditure capital, including:
- where the property wasn’t in a fit state for use before the repairs had been carried out;
- where the price paid for the property was ‘substantially‘ reduced because of its dilapidated state; and
- where there is an agreement committing the taxpayer to reinstate the property to a good state of repair.
HMRC love the word ‘substantially ‘, and taxpayers and their advisers correspondingly tend to find it frustrating. There are few vaguer words in the English language! But perhaps a couple of case studies might help illustrate the general point.
Case study 1 – Abdul
Abdul buys a high street property, which consists of an empty shop on the ground floor, and a two floor maisonette above. The shop, in common with many properties in today’s high streets, has been shut and boarded up for quite a while now, and the maisonette is also in need of significant refurbishment and modernisation.
Abdul decides to do the job ‘properly‘; as retail has had its day in this particular area, he converts the shop into a flat, turning the large plate glass window in the front into a brick wall with a smaller window. The resultant ground floor flat is a completely different sort of property, and lets for considerably more than he had any hope of getting from a retail tenant. The maisonette above had one pokey bathroom right at the back, over a makeshift additional wing, and this is ripped out and two beautiful en-suite bedrooms are created on the top floor. The former bathroom becomes part of the new kitchen, and the whole property is revolutionised in terms of the accommodation offered, such that its former occupant wouldn’t recognise it.
To his dismay, Abdul finds that HMRC are not going to allow him to claim any of the expenditure on works on the properties. The changes are so radical, and the improvement in the run down properties so substantial, that they argue, successfully, that the expenditure is capital.
Case study 2 - Mohammed
Mohammed buys a Victorian house, which has previously been roughly converted into four flats. Plasterboard, chipboard, polystyrene, and glass with wire lattice work abounds throughout the property. However, each of the flats is still usable, and indeed two of them are occupied by long-term tenants.
Mohammed advertises all four flats to let, but on a short term basis, warning the tenants that he is undertaking a rolling programme of refurbishment and modernisation, and that when the time comes for their flat to be done up, they will have to move elsewhere. He proceeds to take on each flat in turn, taking a year in total to refurbish each one. The current kitchens are not actually relocated within the property, but all of the old kitchen fittings, cookers, etc., are ripped out and replaced by swish new fittings. The same applies to the bathrooms, which are fitted with huge shower fittings and modern tiling throughout.
Mohammed replaces all of the old timber window frames with lovely new UPVC.
From the cosmetic point of view, Mohammed’s accounts look better than Abdul’s, because he isn’t claiming a massive amount of expenditure all in one period. Also, if HMRC should enquire into his numbers, despite their reasonable appearance overall, he can point to the fact that all of the flats were in a perfectly usable condition before the works he did. None of his works are fundamental alterations to the property, and would normally fall to be treated as repair expenditure rather than capital expenditure. Mohammed passes the ‘capital versus revenue‘ test with flying colours.
Practical Tip:
Probably we’ve said enough, in the above, to show that there is a substantial possibility of ‘grey areas ‘, and that ‘impression‘ can form a large part of the equation when deciding whether property repairs will qualify for tax relief. However, this is the sort of issue which should be in everyone’s mind, not just when incurring the repair expenditure concerned, but even when contemplating the purchase of a property that is going to need refurbishment.
